Understanding Speculative Bubbles

Understanding Speculative Bubbles

Anyone studying the history of capitalism has noticed that there have been periods of prosperity and periods of recession. While some economists will argue that the boom and bust cycle of capitalism is organic, other economists would argue they are the direct result of speculative investment. Economists Charles Kindleberger and Hyman Minsky have written extensively on the history of and the stages of a financial crisis. The information below is a summary of their ideas.

The Minsky Model

Minsky attached great importance to the role of debt in causing financial difficulties, especially debt connected to the leverage and acquisition of speculative assets for later resale. The diagram below shows the flow for each of the stages. Below the diagram is an explanation for each stage.

The first stage in Minsky’s model is displacement. According to Minsky, some outside shock impacts the economic system. A displacement is a major financial or technical innovation, that present investors with a new type of investment opportunity. It leads to investment mistakes caused by lack of knowledge of the true value of an investment. Displacement varies from one speculative boom to another. It could be the beginning or end of a war, widespread adoption of a new technological invention, or a change to monetary policy.

The second stage is the boom. Individuals and groups begin to borrow money to invest in the new displacement. To finance all the new consumer goods, in the 1920s installment lending was widely adopted, allowing people to buy more than they would have previously. In the housing boom in the 2000s, rising house prices and looser credit allowed more and more people access to credit.

The third stage is euphoria. During this stage, everyone becomes aware that they can make money. Borrowing increases with people going into debt to obtain money to speculate. “Herd behavior” causes prices to spiral up far above the true value of the assets. Early investors have made lots of money. Prices rise, attracting new investors. Many people who remained on the sidelines in the beginning now start speculating. This is where the concept of “mania” comes in. There is irrational behavior and a “bubble” is created.

It should be noted that in the three stages described above, there is easy credit as money is made available to borrow to chase the investment asset.

The next stage is the crisis. The euphoria phase of a bubble tends to be steep but so brief that it gives investors almost no chance get out of their positions. As prices rise exponentially, the lopsided speculation leads to a frantic effort of speculators to all sell at the same time. Prices decrease causing a rush of sales, which causes prices to further decrease. The only way to sell is to offer prices at a much lower level. The bubble bursts, and euphoric buying is replaced by panic selling.

The last stage is revulsion. This is where bankruptcies increase and panic spreads throughout the market. People begin to liquidate their assets as they realize there is not enough money available for everyone to sell at a top price. Bank runs may occur. There are accusations of corruption, and people being swindled. Investors who have lost money look for scapegoats and blame others rather than themselves for participating in bubbles. Recessions are the outcome of the “crash” of the bubble bursting.

It should be noted that in the crisis and revulsion stages, there is a shortage of money and “assets” begin to chase “money”. It is also impossible to predict when a “bubble” will burst.